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BDC Sector Outlook: Wall Street Journal Article – ANNOTATED

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Once in a while the leading general interest financial publications turn to the BDC sector and publish an article about one aspect or another of the sector.

The BDC Reporter is grateful as this brings the BDC sector to the attention of a much wider audience than in our wildest dreams we could hope to reach.

Forty years have passed since the Congress first launched the BDC model and roughly twenty years since funds began to undertake leveraged lending and investing on a wide scale.

Nonetheless, and despite huge growth in AUM; analyst coverage of every public company and all the ink we’ve spilt over the past decade, the sector remains an under-known niche within the financial services sector.

It’s a shame but with every new article in the mainstream press and every new guest on the financial news network, the BDC sector moves a little closer to becoming more of a household word for investors, like REITs.

Nonetheless, because of space constraints and the fact that most of the authors are generalists, BDC-related articles can unwittingly mislead or omit key facts or background that could provide greater context for readers.

Occasionally, the BDC Reporter curates an interesting broad scope BDC article and offers our readers both the original text and our own annotations.

Here is what the Wall Street Journal’s Kristin Broughton wrote about BDCs on May 31 under these headlines:

“Slow Economic Recovery Could Squeeze Smaller Lenders

Nonbank lenders might need to raise capital in the months ahead to support the small- and medium-size businesses who borrow from them”

It’s a fine piece, but the BDC Reporter is gilding the lily for our readers in a manner that – we hope – will be helpful. 

“A slow economic recovery could test the strength of nonbank lenders, forcing many to raise capital if the businesses that have borrowed from them struggle to recover or shut down after the lockdown enforced during the coronavirus pandemic.

Business development companies that lend to small- and medium-size companies expanded rapidly over the past decade, with publicly traded BDCs increasing total assets by nearly fourfold to $83.6 billion as of the first quarter of 2020, according to Refinitiv, a market data provider. Several of these companies, including FS KKR Capital Corp.,New Mountain Finance Corp., and Oaktree Specialty Lending Corp., this month reported quarterly losses, largely due to markdowns on their loan portfolios.

BDC Reporter Notes: There are 49 public BDCs by the BDC Reporter’s count, which is the principal subject of this article. We track 45 of the 49, leaving out 4 BDCs which are venture-capital equity focused and of small asset size. At March 31, 2020 total assets at FMV of the 45 public BDCs was $77.3bn. However Capital Southwest (CSWC) has not reported calendar first quarter results, so the aggregate value is probably slightly inflated.  These numbers for BDC portfolio value greatly understate the true size of the industry – both in its public and private incarnation. Many BDCs have substantial off balance sheet loan portfolios, with a value in the tens of billions, even when adjusted for the ownership of their partners. Furthermore a number of BDCs invest in or – in once case – own Collateralized Loan Obligations. Their investment is typically carried in the junior capital tranches of these vehicles, effectively supporting as much as another $100bn in CLO assets. 

It’s no longer true to suggest BDC investing is limited to “small and medium sized companies”. A slew of BDCs over the years have directed most of their lending efforts towards larger private and public non-investment grade companies. For example Oaktree Specialty Lending (OCSL) reports that the median EBITDA of its portfolio companies is $155mn. Given the 10x-12x valuations common for companies, that suggests many of its portfolio companies are valued well over a billion dollars. By our count, at least a fourth of the BDCs we track invest in portfolio companies with an average EBITDA of $50mn or more, many of which are non U.S. entities. Furthermore, the joint ventures mentioned above typically invest in “lower risk”, lower yield” large cap companies as well. 

The days when the BDC sector could be used as a proxy for the middle market are long gone, as in recent years huge asset managers have joined the BDC ranks. Famous names like the Carlyle Group; KKR, Oaktree Capital Goldman Sachs, Bain Capital, TPG Specialty, New Mountain Finance and BlackRock have joined Ares Management and Apollo Group in sponsoring public and private BDCs (sometimes multiples thereof in both categories).  Most of these new entrants – as well as some existing smaller players – have moved up market in terms of size.

As a result, a majority of BDC assets are now invested in larger cap companies that have been in the news of late including Hertz Corporation; Neiman Marcus; JC Penney; Sears; Borden Dairy; Murray Energy and so on. So – to a degree – what happens in the larger leveraged loan market affects the BDC sector to a degree that was not the case just a few years ago.

In the coming weeks and months, these private-credit lenders will be looking to maintain enough cash to fund loan commitments, pay down debt, and keep their financing options open, analysts said. But for some lenders, that could prove to be challenging, particularly as a large number of borrowers are expected to draw down credit lines to weather the slow pace of economic recovery.

BDC Reporter Notes: The mention of borrowers expected to draw down credit lines is out of date.  Most of the BDCs that offered unused revolver facilities to portfolio companies that could be drawn at will have already seen the funds drawn. As you’d expect – with the memory of 2008-2009 in the mind of good CFOs everywhere – as the crisis developed in March, companies drew down on their revolvers. Anecdotally we get the sense that there was not a great immediate need for the funds, but better safe than sorry. Borrowers may have been concerned of being unable to tap those monies in the future. By the end of March 2020 the bulk of these withdrawals had occurred. In fact, in April and early May several BDCs indicated certain borrowers were returning the drawn amounts as the immediate panic passed. At this stage BDC lenders face little in the way of a risk of sudden, large requests for funds from their borrowers from that direction.

In any case, the scale of BDC commitments to borrowers was never as large as was the case for the banks during the Great Recession. Many BDC lenders – both in the lower and upper middle market – do not cater to their borrowers with revolving lines of credit. Even those who do typically have relatively small amounts at risk. Furthermore, many unused commitments are intended for acquisitions by borrowers or other forms of expansion (which seems a moot issue in the short issue) and require pre-determined criteria to be met before the capital can be drawn. The biggest unused commitment for many BDCs is their unused capital in the aforementioned joint ventures and their organizational documents allow them to defer advancing new funds until they choose to.

So the risk for BDCs is not that borrowers will draw down huge amounts of capital at a time when that commodity is in short supply. 

“In good economic times, they were harvesting the gains,” said Mitchel Penn, an analyst who covers the industry for Janney Montgomery Scott LLC, pointing to strong liquidity generated by prepayments on loans, as borrowers found better deals or sponsors sold portfolio companies. “But then when the virus hit it was like everything stopped in one day.”

Already, lenders such as FS KKR Capital and Golub Capital BDC Inc. have announced capital raises of $250 million and about $300 million, respectively, in recent weeks.

BDC Reporter Notes: As our regular readers will know the FS KKR Capital (FSK) “capital raise” was in the form of unsecured debt and Golub Capital’s (GBDC) an equity Rights Offering, two very different propositions. More pertinent may have been to mention the pending Bain Capital (BCSF) Rights Offering, which will be completed June 9th, and it’s just finished $115mn unsecured note issuance.  

More speculative, but also potentially market moving, are the large number of BDCs that have not yet raised new equity capital but have receive shareholder permission to do so at a price below NAV. If several BDCs choose that route to boost their capital account, the impact on balance sheets, but also on EPS and dividends per share could be broad based. 

“We want to use the proceeds to fortify liquidity and to create more flexibility,” said David Golub, chief executive at Golub Capital, during a May 11 earnings call when asked how he plans to use the new capital.

BDCs have taken steps to shore up cash since the pandemic began to unfold, in some cases increasing their credit lines from traditional banks or slashing dividends.

Harvest Capital Credit Corp., a lender whose portfolio includes a pawn-store operator and a hand-tool maker, said it has shifted its strategy from increasing investments to preserving capital, and has suspended future dividends. Harvest Capital, which posted a $3.7 million net operating loss for the quarter, said it might not be able to extend its bank line of credit that matured on April 30.

“We do have an active dialogue going on, and we’re all hopeful we’ll be able to extend it,” William Alvarez, Harvest Capital’s chief financial officer, said during the company’s May 13 earnings call. “But again, these are unprecedented times, and everybody is treading water very cautiously.”
BDC Reporter: As we’ve reported, HCAP has agreed terms with its lenders. However, that involves an organized repayment of outstandings which will likely cause the BDC’s portfolio to shrink by (25%) to satisfy lender requirements. Elsewhere, Capitala Finance (CPTA) has defaulted under its debt and has not yet arrived at any compromise with its secured lenders. At BlackRock Investment (BKCC) and THL Credit (TCRD) total debt commitments have been reduced and pricing raised. 

The pandemic marks a major test for these nonbank lenders, many of which were formed after the last downturn and moved into higher-risk areas of commercial lending that traditional banks shunned. Credit losses are expected to increase in the coming months, highlighting the underwriting standards that these development companies used when the economy was strong, analysts said.

“We haven’t seen underwriting through a full cycle,” said Chelsea Richardson, an analyst at Fitch Ratings who covers the sector.

Another pressing factor for these lenders is the need to keep up with regulatory leverage ratios, analysts said. Maintaining a debt-to-equity ratio of below two-to-one is critical for CFOs who want to keep their financing options open as they move through the downturn, according to Lisa Kwasnowski, an analyst who covers the industry for DBRS Morningstar. Anything higher could put companies in violation of their bank loan or debt agreements, and potentially take a number of financing options, such as obtaining an additional loan, off the table, she said.

BDC Reporter Notes: Not meeting asset coverage/leverage requirements for BDCs is much more serious than just breaking lender covenants. Under BDC regulations, tripping this wire forbids BDCs from borrowing any further monies and impacts how distributions are paid.

The WSJ does not mention that the Congress – rashly in our minds – increased the debt to equity limits for the BDC sector early in 2018, lowering asset to debt coverage from 200% to 150% (effectively increasing debt to equity allowed from 1:1 to 2:1). This has contributed substantially to the current problems at BDCs as most every player in the intervening period has been bulking up on leveraged loan investments at the very end of the economic cycle. This high leverage has contributed to the drop in book value across EVERY BDC that reported quarterly results in March 2020 and the liquidity constraints many are under. The bigger portfolios get, the harder they fall – as Jimmy Cliff warns us – when asset values drop.

But staying below the regulatory limit—or below lower targets that BDCs set internally—could be challenging. BDCs mark their loan books at fair value, meaning the value of their loan portfolios can fluctuate. If loan values continue to drop as businesses struggle to reopen, leverage ratios could tick higher as a result of equity values declining.

BDC Reporter Notes: There’s a complex set of forces at play. As anybody who watches leveraged loan prices will know, since the end of March their value on average has been increasing. Here’s what S&P Global Market Intelligence had to say on the subject:

“The S&P/LSTA Leveraged Loan Index gained 3.80% last month, the second-highest return in the last 12 months, after a 4.50% gain in April. The total effect of the April/May rebound is an 8.47% gain, following a 12.37% loss in March, the second-worst decline in the 23-year history of the Index”

This was reflected in comments made by several BDCs on their conference calls in May. Several indicated that their portfolios had gained back one-third of the value lost in March and that percentage may have increased further in recent weeks. 

However, a large number of portfolio companies that were written down in March may continue to deteriorate in value because of the impact of the pandemic on their business operations. The extent of the damage – and thus of the fair market value write-downs – may not be known for several quarters and the ultimate losses could be significant and – potentially – much more severe than already booked.

As a result, we may have a situation in the IIQ 2020 BDC results where the majority of written down assets move up modestly towards par, which would boost BDC NAV value in the quarter. However, some or all that benefit could be offset by the large minority of companies whose business has been seriously impacted and are at danger of defaults or loss. When one adds the ten percent or so of companies already struggling before Covid-19 struck and the 20%-30% that have been newly impacted across a range of sectors (energy, travel, restaurants, entertainment, health care, mining etc) the cumulative impact could be severe. Moreover, while the bulk of the positive upgrades to portfolio values will occur in the short run, the damage to underperforming investment values may take several quarters to play out, well into 2021. This might result in the aggregate book value of BDC net asset values (down 15%in the IQ 2020) to increase or stabilize in the IIQ and then drop in future quarters. Of course each individual BDC will be different but the forces at work will operate sector wide. 

That could push more BDCs to raise capital from equity investors, analysts said. And demand for lenders with a solid understanding of niche markets, and a strong record of lending to distressed companies, could be strong, Ms. Kwasnowski said.

BDC Reporter Notes: The WSJ is undoubtedly right that these factors could cause more equity capital to be raised, as we discussed above about BDCs getting permission to sell stock below NAV.

However, that’s unlikely to be the main source of capital given the cost; the long time frame involved and shareholder dilution, which can often be extreme and still only raise modest amounts.

Much more prevalent for BDCs under pressure either currently or in the future will be a deliberate policy of selling off or allowing the repayment of assets without replacing them. Effectively, this means the partial wind-down of BDC portfolios, which has the benefit of creating liquidity; relieving pressure on leverage metrics and from lenders and can be accomplished in relatively short order and without shareholder dilution.

Aiding in this process is that – as we’ve seen – loan assets that are not in trouble due to Covid-19 continue to be in high demand in the markets. Unlike in 2008-2009 there is not a complete closure of the market when there were no buyers for a period. Furthermore, some M&A activity continues which results in repayments. This allows BDCs that need to and have larger sized, well performing loans to use them to bring down their leverage and improve liquidity. 

That strategy is underway at a host of BDCs is already underway and should continue. The likely result is that overall portfolio assets in the BDC sector will drop in value – after adjusting for FMV changes. This, in turn, will place pressure on certain BDCs earnings and dividend levels as smaller portfolios mean lower profits even before one figures in lower loan yields thanks to the implosion of LIBOR and the impact of non performing investments.  

We currently estimate 31 BDCs out of 44 that we’ve analyzed in this regard will suspend or reduce their distribution levels from the IQ 2020 level by year’s end. Harder to estimate are the dollars involved for each BDC given the myriad moving parts.

The likely highlight of the Covid-19 crisis will not necessarily be a huge upsurge in equity raising (which should relieve existing BDC shareholders who will bear the brunt of the dilution involved) but a much broader decline in earnings and distributions and the roll-backs of payouts that – in some cases – had gone unchanged for years. That, too, will “dilute” shareholder returns as portfolios are right sized. 

“There’s a reason why these entities exist, and the strong ones may find ways to benefit,” she said.

BDC Reporter Notes: The article ends on a high note but does not give much context.

We assume the author is thinking of the several BDCs that – to date – have weathered the drop in portfolio values well and are sitting on substantial liquidity.

These BDCs have both the resources to help out existing portfolio companies – at a price – and begin to make new investments, either in older loans at better prices or for new transactions.

The success – or otherwise – of the BDCs that we expect to thrive (which we believe amounts to 11 names) will also be decided by what happens to their credit quality in the months ahead.

Those BDCs which can dodge the bulk of the credit bullets coming their way and with the resources to increase their portfolios (these are related items) may be able to boost both earnings and dividends down the road. 

Write to Kristin Broughton at [email protected]

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